Evaluate Your Financial Situation Using the
Debt-to-Income Ratio
Most people have some kind of debt, whether it is in the form of a mortgage, student or auto loans or credit card debt. It’s important to understand that not all debt is bad. Carrying a mortgage, for example, can make perfect financial sense and help you to enjoy the benefits of home ownership while achieving longer-term financial goals as the home (hopefully) appreciates in value over the years. In carrying and managing your debt, you simply need to pay attention to the cost of that debt. Making a determination as to whether you are carrying too much debt can help you to avoid negative financial consequences in the future.
Your Debt-to-Income Ratio
One of the best and easiest ways to calculate your debt load is through a debt-to-income ratio analysis. This measure will tell you the percentage of your income that you are paying toward debt. The calculation of this ratio is simply:
Debt-to-Income = Monthly Debt / Monthly Income
To perform the calculation, you can take your total annualized income and divide it by twelve to arrive at your monthly income. Then calculate your total monthly debt, including mortgage, student loans, car loans, minimum credit card payments, and other personal debt.
In evaluating the ratio, many financial advisors recommend 35% or less as a healthy measure and a worthwhile goal. When the percentage is up around 45% or higher, there is significant cause for concern.
If You’re Carrying Too Much Debt
Here are some steps you might take if, after performing the ratio analysis, you determine that your debt load is too high:
(1) Establish a Monthly Budget: This exercise will enable you to a compare your income to your expenses and determine how you can find monthly savings that can be applied toward paying down your debt. Many people find that it is helpful to categorize your monthly expenses as either “necessities” or “luxuries” so you can easily determine which expenses can be readily eliminated.
(2) Consider Refinancing Your Mortgage: Many homeowners will look at the possibility of refinancing their mortgage when they are trying to cut monthly expenses. When considering this option, though, you need to compare the costs of refinancing (points, appraisal, attorney fees, etc.) and compare that to your monthly savings. The shorter the timeframe to break-even, the more sense refinancing might make.
(3) Consider Debt Consolidation: While consolidating your debt to a single creditor can help you to more easily manage the debt at a lower overall interest rate, the lower rate might come with an extended term. If this is the case, you might end up paying even more to the creditor. You should carefully evaluate this option and discuss it with a financial advisor before moving forward.
Debt Consolidation Calculator
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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